Bank Stress Tests May Pose Major Obstacle to Stock Rally

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Uncertainty over bank stress testing and the billions in loan losses the institutions will have to cover poses a threat to the stock market rally.

Results of the tests are scheduled for release Thursday, and some analysts suspect that the numbers could trigger a leg down for a market that has used strength in financial stocks to pave the for an eight-week run higher.

"My sense is we have a disconnect between the hopes and expectations on Wall Street and the reality on the ground," said Martin Weiss, president of Weiss Research and a persistent critic of the stress testing process as implemented by the government.

As written, the current process takes only a slightly worse-than-consensus look at what economists think will happen and not a worst-case scenario typical of bank stress testing, Weiss says.

A true testing would show that six of the nation's 19 largest bank--the pool being used for the stress tests--are in real danger of failing, Weiss said, listing those as JPMorgan Chase, Goldman Sachs, Citigroup, Wells Fargo, Sun Trust and HSBC.

Yet even with what Weiss considers lower standards many of the banks will remain in trouble, and investors are certain to take notice.

"Overall I believe that the consensus will be that too many large banks are not coming out well in the stress tests, and if the tests were adequately severe ... there would be even more institutions that will fail the tests," he said. "I think that would trigger another big decline on the financial stocks. I don't know if it will happen immediately, but I see a major decline in financial stocks."

Standard & Poor's has conducted its own round of stress testing and predicts major shifts in the industry due to the billions that banks will need to be made whole again.

Reflecting concerns over the criteria the government is using, S&P applied standards that were more strenuous and based on economic realities not seen since World War II, said S&P credit analyst Tanya Azarchs. S&P says current bank ratings probably don't reflect the conditions that were expected and need to be changed.

"The market was thrown off by the economic assumptions that the Fed laid out for the groundwork of how the banks should think about the stresses that they perform," Azarchs said. "We now think the cycle is going to be much more severe. So that is not discounted in the ratings and that means we think that loss rates for any given loan category will likely be higher than they have been in living memory."

Whether any banks fail depends on a number of factors, including just how aggressive the government plans on getting to save the large institutions.

Banks who don't have enough capital on hand to cover their losses will have to time to raise it, but face a difficult environment in which to do so.

"If the market begins to think that a bank needs to raise a significant amount of capital and they can't do it--certainly in this market it's difficult to raise any privately--we get the crisis of confidence that forces in a liquidity problem," Azarchs said. "That could cause a run on the bank either from institutional investors or depositors. That forces the bank to be closed. That scenario is really hard to foretell because of the question of psychology."

For the market, then, decisions will be based primarily how well banks can convince investors that they can cover their losses.

"There are a lot of moving pieces here. What we have found is the loss rates are already approaching previous highs," Azarchs said. "The economy is still deteriorating, the unemployment rate is still going up and we haven't neared the end of it. So we can only surmise it's going to be a whole lot worse than anything we've seen since World War II."

How Hard of a Hit?

Other analysts have concerns as well.

The delay in releasing the results from Monday to Thursday is just the latest blip in the process but one raising the hackles of those already suspicious of the tests' ability to accurately read bank health.

The delay in releasing the results has cause the situation to go "from the state of farce to tragicomedy," said Richard Bove, analyst at Rochdale Securities.

Bove sees mid-sized regional banks coming under pressure as well from the tests, even though they aren't included, as confidence wanes in the industry. As many as 150 mid-sized regionals could fail by the end of the year while mergers also will abound for regional banks in Florida, the Midwest and the Pacific Northwest, he added.

Even banks that won't fold also will be pressured and could see their stocks hit.

Merrill Lynch issued a warning about several large institutions involved with the tests, cutting profit estimates for Bank of America (NYSE: BAC), Citi, Sun Trust, US Bancorp (NYSE: USB) and Wells Fargo.

However, Merrill added that BofA and US Bancorp ought to be OK for the long run.

Slideshow: World's Safest Banks

"We expect Bank of America to recover and outperform longer-term but, similar to peers, the stock could remain volatile near term due to sharply rising credit losses and concerns about stress tests and capital," said a report Merrill issued.

"We think U.S. Bancorp is better positioned than peers to withstand the current cycle and stress tests, despite rising credit losses," the report continued. "We expect U.S. Bancorp to continue to trade at a substantial premium to peers as a flight-to-quality bank due to better credit performance and lower capital markets risk."

Maybe Not That Bad

Market optimists believe the release of the stress test results could be a non-event for several reasons.

Initially the Obama administration wanted to keep the test results private, reasoning that if word got out that individual institutions came out poorly it could trigger a run on those banks. Since then, the administration has relented and agreed to release the results, though some confusion remains over just how detailed the data will be.

The most recent statements from the administration indicate that the data will be fairly complete both on individual institutions and on the 19 banks as a whole.

That has some hoping that the test results at least aren't bad enough to cause panic among investors.

"My guess is that the people in the administration are smart enough that they would not set the stage for an event that could derail either the stock market recovery or economy recovery by putting out confidence-breaking bad news," says Peter J. Tanous, president and director of Lynx Investment Advisory in Washington, D.C.

"It would seem stupid," he adds, "for the administration to announce that it's going to do these tests and reveal their results without having a clue as to what those results could look like and what effect they could have on the markets."

Moreover, the market may not even be that focused on financials anymore after the sector has been beaten down so badly over the past two years, said Peter Miralles, president of Atlanta Wealth Consultants.

"The market is not taking its cues from what's going on in the banking system right now," Miralles said. "The market is taking its cue from other businesses that are doing well."